The minimum percentage of their customers' total demand deposits (checking
account balances) that banks are legally required to keep on hand in cash or as
deposits in their accounts at the regional Federal
Reserve bank. In the United States, the Federal Reserve's Board of Governors
is empowered to set the reserve requirement for member banks at its discretion.
This power provides one of the Fed's more powerful policy tools for influencing
the banks' willingness and ability to extend or call in loans, and thus to
influence the size of the money stock and the level of prevailing interest rates.
Lowering the reserve requirement is expansionary. Lowering the
reserve requirement increases the bankers' availability of funds to make more
loans, thus tending to expand the money stock and (in the short run at least) to
lower interest rates and encourage both consumers and investors to buy more.
Raising the reserve requirement represents a contractionary move by the
Fed. Raising the reserve requirement restricts the bankers' ability to
make more loans, and those banks that were already operating just barely above
the old reserve requirement will probably be forced to call in some of their
existing loans to meet the tougher new requirement, thus tending to shrink the
money stock, raise interest rates, and thus reduce the volume of purchasing on
credit in the economy as a whole.